Wednesday, December 16, 2009

Who Studies Near-Zero Interest Rate Economies?

Professor Krugman has repeatedly emphasized that little of what we understand from past business cycles applies today, because (so he says) interest rates are near zero today. He concludes that the only useful studies are those of other eras of near-zero interest rates, and as a result one can ignore what Professor Barro, Mankiw and I (and anyone else who uses "traditional" economics) say about government policy.

First of all, he has presented no evidence that a low-interest rate economy responds differently to fiscal and regulatory policy, while we have plenty of evidence that fiscal and regulatory policy are having very much the same effects as they always do.

Professor Krugman's remarks contrast starkly with my JPE paper "Extensive Margins and the Demand for Money at Low Interest Rates", which empirically examines the extent to which "normal" economies respond to shocks differently than low-interest-rate economies, rather than assuming that low interest rates necessarily transform those responses.

Even if we accept on faith that only low-interest rate economies must be studied, then one has to pay more attention to Barro's and Mulligan's studies, rather than less, because those studies have been conducted on economies with nominal interest rates at least as low as today's.

The chart below shows the yield on 3-month Treasury Bills by year 1937-47 and 2005-15. Year is measured vertically and nominal yields are measured horizontally. Thus, near zero yields are seen on the left border of the chart.

As you can see, yields were at least as low during the episodes studied by Barro and me as they are today. For example, the average yield in 2009 was about the same (just a bit higher; shown by the red curve) as the average yield in 1941 (shown by the blue curve).

For years, Professor Barro's Macro textbook has used World War II to estimate a government spending multiplier. (He and Charles Redlick have recently revisited WWII, and other U.S. defense spending episodes). I have looked at the labor market during World War II. Both of us looked at the expansion of government circa 1941-42 and the contraction of government 1946-47.

Interestingly, Professor Barro and I have done vastly more work on low interest rate economies than he has, despite the fact that he is the one so fascinated by them. I guess the conscience of a liberal is not without its inconvenient truths.

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